Why United Tech Is Now the Most Attractive Conglomerate Stock

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United Technologies Corp. (NYSE: UTX) shares have made a slow start to 2017, up only about 3% so far. However, one brokerage firm sees smooth sailing ahead for this company, as it believes that headwinds surrounding the stock are beginning to dissipate.

Merrill Lynch added United Technologies to the US 1 list, which represents the best investment ideas of the firm. In Merrill Lynch’s view, underperformance was driven by overhang from Pratt & Whitney and Otis. However, the firm expects 2017 to be the trough in segment operating margins as headwinds begin to alleviate.

United Technologies was maintained at a Buy rating with a price objective of $130 (versus a prior close of $111.93). This is implied upside of 16%.

The firm detailed the relationship of Pratt & Whitney in its report:

The entry into service of the Pratt & Whitney Geared Turbofan (GTF) was bumpy. Pratt & Whitney faced a shortage of hollow titanium aluminide blades, which delayed engine deliveries in 2016. Additionally, the GTF encountered initial field performance issues from “rotor bow” due to asymmetrical cooling as well as recent issues from the number 3 bearing. However, in our view, these issues are common for a clean sheet product and do not undermine Pratt’s strategic success in re-entering the narrowbody engine market. We note that United Tech was at the risk of irrelevance in the narrowbody engine market since it lost the Boeing 737 Classic program to GE and Safran’s CFM-56. We expect negative headlines from the GTF program to ease as teething issues are resolved.

Separately, Merrill Lynch noted that 2017 is a challenging year for Otis as the company invests more money on research and development (R&D) to upgrade its product portfolio and actively regains market share in original equipment (OE). Considering that OE margins are dilutive to segment margins, the strategic push to invest in the pipeline for aftermarket hurt margins in 2017. However, as incremental R&D tapers off and the OE market normalizes, Merrill Lynch expects Otis margins to improve to 17.8% in 2018 from the expected 17.0% in 2017.

Merrill Lynch gave its investment rationale on United Tech as follows:

We like UTX’s balanced growth, end-market exposure, op leverage and execution. UTX has strong market positions in both aero/def and global infrastructure with a portfolio that includes: Otis, Hamilton Sundstrand, Pratt & Whitney, Climate, Controls & Security, and Sikorsky (in discontinued operations). Global balance and end-market diversification provide a hedge during periods of economic uncertainty. A conservative balance sheet and strong free cash flow conversion allow for continued share buybacks and M&A.

Shares of United Tech were last seen up 1% at $113.00 on Tuesday, with a consensus analyst price target of $118.87 and a 52-week trading range of $96.89 to $114.44.